How do banks make money?

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Banks offer a variety of free services such as savings accounts and free checks. In fact, they may even pay you to leave money in your bank account. In addition, you can increase your earnings by using certificates of deposit (CDs) and money market accounts. Most banks and credit unions, except those that are exclusively online, also have physical branches with staff. They also operate call centers with extended service hours.

But how do banks finance all these services? Banks derive their income from investments (or loans and loans), account fees and additional financial services. When entrusting your money to a financial institution, it’s essential to understand their business model and the fees they charge, but it’s not always clear how banks are remunerated. There are several ways for banks to generate revenue, including investing their customers’ money and charging fees.

The gap

The traditional way for banks to make a profit is to borrow and lend money. Banks collect deposits from customers (essentially borrowing this money from account holders) and lend it to other customers. The mechanisms are a little more complex, but that is the general idea.

Banks remunerate depositors who keep their money in savings accounts, CDs and money market accounts by paying interest at low rates. They usually don’t pay anything at all into chequing account balances. At the same time, banks charge relatively high interest rates to customers who take out mortgages, auto loans, student loans, business loans or personal loans.

The difference between the low rate banks pay and the high rate they charge is called the “spread,” sometimes referred to as the bank’s “margin.”

For example, a bank pays an annual return of 1% on money deposited in savings accounts. Customers who get auto loans to buy new cars pay an average annual rate of 6.27%. This means that the bank theoretically makes a profit of 5.27% on these funds, but potentially less if operating costs are taken into account. She can make even more profit with credit cards. According to the Federal Reserve, the average annual rate for credit cards is 16.30%, according to the most recent data from October 2021.

Investments

When banks lend your money to other customers, they are essentially “investing” those funds. But banks don’t just invest by lending to their customers. Some banks invest heavily in different types of assets. Some of these investments are simple and secure, while others are complex and risky.

Regulations limit the extent to which banks can speculate with your money, especially if your account is insured by the FDIC. However, these regulations tend to evolve over time. Banks can always increase their income by taking more risk with your money.

Account holder fees

As a consumer, you’re probably familiar with the bank fees that affect your chequing, savings and other accounts. Although these fees are becoming easier to avoid, they still contribute significantly to a bank’s profits.

For example, Bank of America’s Advantage Plus chequing account charges a monthly maintenance fee of $12. Over the course of a year, this fee will cost you $144. However, you may be able to avoid these monthly maintenance fees by maintaining a certain balance or setting up a direct deposit.

Banks also charge fees for certain types of actions and “mistakes” you make on your account. If you have overdraft protection, it will cost you about $30 each time you exceed your balance. Even worse, you can still pay this fee even if you have opted for non-membership. Did you issue an NSF cheque? It will also cost you. There is a long list of fees or charges related to account activity, including, but not limited to:

  • ATM fees (including fees charged by your bank, as well as fees from the bank that owns the ATM)
  • Replacement of lost or stolen card (and additional charges for express delivery)
  • Early withdrawal of a CD
  • Prepayment penalties on loans
  • Late payment penalties on loans
  • Inactivity fees
  • Fees for paper statements
  • Fee to speak to a teller if you have an inexpensive online account
  • Requests for Chargeback

Service Fees

In addition to generating income through borrowing and lending, banks offer optional services.

You may not have to pay for some of these services, but many banking customers (individuals, businesses, and other organizations) do.

Offers may vary from bank to bank, but here are some of the most common services:

  • Credit cards: You already know that banks charge interest on your loan balances, and they can also charge card users an annual fee. They also collect interchange revenue or “transaction fees” every time you use your card to make a purchase. In contrast, debit card transactions bring in much less revenue than credit cards. That’s why merchants would prefer you to pay with cash or a debit card, and some stores even charge customers this fee as surcharges for credit card payments.
  • Cheques and money orders: Banks issue cashier’s checks for large transactions, and many also offer money orders for smaller amounts. The fees for these instruments are often in the range of $5 to $10. You can even order new personal and business checks from your bank, but it’s usually cheaper to redeem them online from a check printing company.
  • Wealth Management: In addition to standard bank accounts, some institutions offer products and services through financial advisors. Commissions and fees, including the costs of assets under management, arising from these activities supplement the bank’s profits.
  • Payment Processing: Banks often handle payments from large and small businesses that want to accept credit cards and ACH payments from their customers. Monthly and per-transaction fees are common.
  • Positive Pay: If you’re worried about thieves printing fake checks with your business account information, you can ask the bank to monitor all outgoing payments before authorizing them, but of course, this comes at a cost.
  • Loan fees: Depending on your bank and the type of loan, you may pay an application fee, an origination fee of about 1%, discount points or other fees to get a mortgage. These fees are in addition to the interest you pay on your loan balance.

Some credit unions pay interest and charge fees similar to what you would find in a traditional bank, so the different structure is just a formality.

How Credit Unions Work

Credit unions are customer-owned institutions that operate more or less like banks. They offer similar products and services, generally have the same types of fees and invest deposits by lending or investing them in the financial markets.

Because credit unions are not-for-profit organizations and customers own them, they can sometimes pursue less profit than traditional banks. They can offer higher interest rates, charge less interest on loans, and invest more conservatively.

Frequently Asked Questions (FAQ)

What do credit unions do with the profits they make?

Credit unions return profits to members, who also own property, in the form of higher savings rates, lower loan rates and lower fees.

How much money do banks make?

In the first quarter of 2022, banks made a profit of $59.7 billion, down 22.2% from the first quarter of 2021. Bank profits fluctuate according to market, economic and political conditions.

In conclusion, banks generate income through the interest earned on the loans they grant, the fees charged to account holders and the additional financial services they offer. Investments and the differences between the interest rates they pay to depositors and those they charge borrowers also contribute to their profits. Credit unions, as customer-owned institutions, operate similarly to banks, but they can pursue less profit and offer better benefits to members.

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